Thursday, August 22, 2013

What Determines the Return on Gold?

Gold glitters, but from an investment perspective it does little else. It is backed by neither cash flows (like stocks are) nor a value at maturity (like bonds are). It's just a metal that, historically, has always been highly valued: a value that exists beyond its role in jewelry or in industry.

So what gives? Broadly speaking, when people make a bull case for gold, they tend to talk about two catalysts. First, they argue that because central banks are engaging in expansionary monetary policy, this will lead to massive levels of inflation that will drive gold prices higher. Second, they argue that gold is valuable because it acts like a panic button and serves as insurance against crisis. These in fact, were the primary motivators behind Paulson's famous bet on gold. In this post, I hope to show that the theory underlying (1) is flat out wrong, and that the logic behind (2) does not correspond to the actual challenging facing the world right now.

So let's first talk about inflation. The argument goes that since gold is a precious metal with "intrinsic" value, its price will rapidly appreciate in an environment of rapid inflation. Unlike a fiat currency, gold cannot be "debased" and therefore even if the Fed prints too many dollars, the gold coins will still hold onto their real value. In a world in which wheelbarrows of paper money buy only loaves of bread, gold will still make sure you can still eat. This value across all levels of inflation means that gold prices spike if inflation rises, and thus holding gold can hedge that risk.

Most arguments against this thesis have come down to (correctly) observing that central banks have not caused high levels of inflation. Given high levels of slack in developed economies, central banks are also unlikely to cause high levels of inflation. But this concedes too much. In truth, inflation hardly drives gold prices at all.

When people think of high inflation, they naturally gravitate towards the late 70's, early 80's -- a time of rapid growth in gold prices. But this was a special time for many reasons, not least of which was the United States decision to suspend dollar convertibility. But ever since those inflationary years, although gold has had its ups and downs, its price has actually been relatively uncorrelated with levels of inflation. In fact, if you look at the scatter plot below, you'll notice that the positive relationship between gold and inflation is almost entirely driven by three data points: 1974, 1979, and 1980. Once you drop those three years worth of observations, you go from the upward sloping dotted line to the solid downward sloping one. This suggests that inflation is actually a horrible predictor of where gold is going to go, and that we should look elsewhere for a guide.

So what is this other guide? Real rates. In fact, yearly return on gold is almost entirely determined by a the 10 year treasury yield minus the year over year inflation rate. To see this, consider the following scatter plot. Unlike the gold-inflation relationship, the real interest relationship is not driven by just a few data points. Both the 1970's and 2011 gold price spikes are explained by this relationship. Moreover, the relationship between the variables seems consistent through all levels of the real interest rate. This is evident from the fact that the non-parametric loess fit (the red line) and the linear fit are roughly consistent with each other.

This observation makes the most sense in the context of a Hotelling model -- a note that Paul Krugman has previously made. For a full explanation of the mechanics of the Hotelling model, I suggest you read Krugman's post. But the intuition for the model is that a higher real interest rate lowers demand for gold since the opportunity cost of holding it increases.

The relationship holds with more recent data as well. As seen below, the price of gold has been almost entirely determined by the yield on the 10 year treasury inflation protected security - a measure of future expected real rates. Admittedly, there is something puzzling going on. Whereas the historical relationship seems to run from gold growth rates to the level of the real interest rate, the gold price/TIPS relationship seems to suggest the gold price level is related to the level of the real interest rate. Nevertheless, the moral of the story is the same: higher real rates are bad news bears for goldbugs.

So why do people associate inflation with high gold returns, when in actuality gold returns are driven by real rates? It's because they reason from a price change and ignore the cause of inflation. The inflation seen in the 1970's and 1980's was very unique because it was the result of contracting aggregate supply, which had the effect of both raising inflation whilealso lowering the attractiveness of investment projects (i.e. lower real rates). However, inflation can also be the result of increasing aggregate demand. In this case, especially if the aggregate demand is pulling the economy out of a slump, the effect on the real interest rate is ambiguous to slightly positive. Therefore the relationship between gold and inflation is less clear cut.

This leads to an interesting conclusion about inflation hedges in general. Because there are two types of inflation -- supply and demand side -- it is important that you're careful with what kind of inflation hedge you're buying. If you're worried that "earthquake risks" will devastate the supply side of the economy, go ahead and buy gold. But if you're worried about a lack of central bank discipline, then you're better off buying the the 10 year inflation protected security while shorting the 10 year treasury.

So if gold isn't a good hedge against inflation, is it at least a good hedge against economic crises? Not all of them. If the crisis is one that leads to a fall in confidence and surge in desired savings, then real rates may fall and the price of gold may rise. But if the crisis is one that leads to a fall in savings and a rise in real rates, holding gold will end up exposing more of your portfolio to the worst of a crisis..

This is particularly relevant given recent Chinese and Indian economic stress.

If China undergoes a financial crisis, the most likely result will be capital flight. In this process, China will be forced to reduce its savings and investments as it rebalances. But in this case, since China will no longer be able to invest as many funds abroad, real rates rise and the gold price should actually fall.

Moreover, if China undergoes such a crisis its retail demand for gold will fall -- another strike against the insurance quality of gold.

Similarly, India's currency is under attack and its central bank may need to draw on its reserves of foreign currencies to stem the slide. Below I have a skew graph from a few weeks ago showing the depreciation that option markets were pricing in. As can be seen, there's quite a bit of depreciation risk in the tails. The effect of any such depreciation will be quite similar as in the Chinese case. Demand for foreign (i.e. American) assets will fall, thereby pushing U.S. real interest rates higher.

So while gold might have been good insurance it the past, it is not right now. Because the tail risks facing the global economy are much different than in the past, holding gold will end up amplifying risks instead.

The conclusion from all this analysis is that gold does not "march on a different beat." In the parlance of finance, it is not a source of uncorrelated returns. Nor is it a pure result of market psychology. In fact, given gold's relationship with real rates, it can be best described as a leveraged bet that real rates will fall. But with obscene amounts of volatility and low long run returns, it's not clear why anybody would want to hold gold at all.

Well given that low-to-negative real rates have been the reality quite recently (although I'd argue more as a product of market conditions than the policies of Fed chairmen), it is understandable that gold did very well in the last 10 years denominated in dollars. In the next 10 years, a similar real rate pattern may not hold. It's uncertain where real rates will go, and epistemologically I largely agree with Noah that gold is a bet on people wanting to hold gold. In the next 10 years, I foresee lots of technology-driven investment opportunities driven by things like 3-D printing, alternative energy, exotic modes of transport, etc. Gold will drop off a lot of people's horizons. Holding a small amount of physical gold is still a good antidote to people worried about financial system counterparty risks, but in all honesty these have been brought under control in the last two years.

All of these are factors in why I conclude that the gold bull market is over, and why I worry for ordinary investors who thought they were buying a sure thing, and cannot afford to lose the money they invested.

"Holding a small amount of physical gold is still a good antidote to people worried about financial system counterparty risks, but in all honesty these have been brought under control in the last two years."

You appear to be assuming, Mr. Aziz, that such control can continue to be exercized in the face of a tightening monetary policy. This remains to be seen, and history tells us that this isn't likely given that we are now on the third round of QE which is to continue indefinitely at a varying pace of purchases. If the Fed can begin to actually begin to tighten without crashing the stock market, then your theory will prove to be more plausible, as long as high inflation has not yet manifest itself.

My guess is that inflation expectations and inflation itself will remain subdued until the investing public comes to the realization that the Fed will never be able to exit. The expectations of tapering QE next month are a sign that the investing public is beginning to look more closely at QE, why it is needed, and when the Fed can stop doing it. QE is becoming like your in-laws overstaying their welcome. When the public realizes that the in-laws have actually sold their house and moved in for good, that is when the inflation expectations will begin to rise.

Neil — I agree that the Fed shouldn't taper now. The recovery is still very weak and unemployment is still high. Tapering now would be in contradiction to the Fed's own self-determined goals of getting inflation up to 2% and unemployment below 6%, even if I and many others doubt the efficacy of monetary policy in achieving these goals. In the future when the economy has improved, tapering should be possible especially with a strong recovery from technology gains, and successful private deleveraging (relative to income). In fact, with a strong recovery tapering won't just be possible, it'll be necessary as credit appetite increases.

Yichuan — Gold is rather unique inasmuch as that it's a physical financial asset. There are lots of physical assets like houses, cars, land, etc that are not subject to counterparty risks but gold is one of the few (alongside physical fiat currency) that are also financial assets, and the only one which is also independent of any central issuer (i.e. given value purely by the market, not by law). In normal times this is irrelevant, but in a world of bank runs, bank failures, and fears of things like hyperinflation or war these are quite desirable characteristics for a lot of investors.

This argument is based on an historical view of Western economics and takes no account of the cultural significance of gold in Asia.

While buying gold is always a bet on others wanting to buy gold over the next few years, the likelihood of that bet being a winner increases, in my view, with the level of wealth in Asia. Would you like to bet against increases in the level of individual wealth in Asia?

Rising individual wealth would make me want to balance out of gold even more. Since the price of gold is primarily determined by real rates, then the rising level of wealth (and the rise in the consumption ratio that accompanies it) is a further tailwind for pushing the real rate up, which would cause gold to do even worse.

Dude...are you seriously claiming that the tiny amount of demand for physical gold from retail buyers in Asia has any effect when compared to the massive amounts held by central banks and ETFs? It's literally a drop in the ocean. You remind me of the WGC guy claiming that gold is going to see a bid because of Diwali.(as an aside, I think gold has further upside from here, but not because of people buying jewelry...that's goldbug talk.)

"But this was a special time for many reasons, not least of which was the United States decision to suspend dollar convertibility."

The U.S. decided to suspend convertibility into what exactly?

"the price of gold has been almost entirely determined by the yield on the 10 year treasury inflation protected security - a measure of future expected real rates."

But the Fed is artificially affecting the ten year rate through QE, so if the ten year note yield isn't an accurate measure of actual public demand then this measurment that you cite can't be accurate either. The ten year yield is like a ball being held under the water by QE, which is why QE will, in my view, never completely cease.

By dollar convertibility I mean the convertibility of the dollar into gold. See [http://en.wikipedia.org/wiki/Nixon_Shock]

I think you need to abstract away from QE. QE or not, financial markets should move together -- they should evolve according to general equilibrium. Therefore even if it's QE that's lowering real rates, that still changes the opportunity costs of investing in different assets, which then affects the price of gold.

As far as dollar convertibility goes, I just wanted to highlight your observation that the U.S. dollar was in fact at one point convertible at a fixed price into gold. It was at that point in 1971, after being the de facto form of money in advanced civilized cultures for millenia, that gold became just another commodity, and paper, or merely digits on a screen, in and of itself, became money. I submit to you that this era of a pure fiat world reserve currency is ending, and that QE is the main policy that will ultimately bring that end about.

That is why to abstract away from QE is to ignore what is most significant. QE is a radical new policy, only 5 years old with regard to the U.S. It is a game changer, so I view the situation we have today in the financial markets as unprecedented and generally uncomparable to market action of the past. QE, in combination with the rock bottom funds rate, has distorted practically all markets beyond the ability to properly analyze. Just think if QE had never been implemented here in the states, and the large banks had not been bailed out. The world would now be a completely different place, and the way people conduct business and banking would be unrecognizable. Are we really supposed to believe that all those radical changes and transformations that would have occurred were magically avoided by an easy monetary policy? I think it more likely that those disasterous consequences, rather than being avoided, were simply transferred away from the financial and housing sectors, and will ultimately be realized in the U.S. currency market and probably other currency markets as well. Of course, this hazard transference takes some time, and could theoretically still be avoided if the Fed were to tighten policy before inflation expectations begin to take hold.

I realize that you see correlations in certain data points that convince you of your position. But in the grand scheme of things QE and a low funds rate is the only thing keeping 2008 on a larger scale from happening again. Money printing is now the life-blood of the U.S. economy. So in my view, precious metals are one of the best places to have your wealth right now.

"The ten year yield is like a ball being held under the water by QE, which is why QE will, in my view, never completely cease."

This is what Bill Gross at PIMCO thought when QE2 ended, that the ten year yield would shoot up. He was wrong and PIMCO lost a whole lot of money. When QE2 ended, the ten year yield actually fell slightly.

I think this time is different because I believe bonds have topped out after a 30+ year bull market, and yields have now put in their lows.

But you raise an interesting question. If bond yields dropped from the June 22nd meeting to the September 21st meeting in 2011, why did the Fed think it necessary to implement Operation Twist at that time? It makes one wonder if bond purchases are really about keeping yields low.

I think, as I said above, that QE is really an ongoing bailout of the primary dealer banks. They need it to survive. If I'm right about this, then QE can never stop completely for more than maybe a few months. Any more than that and those banks would start to self-destruct once again. And the funds rate in stuck at under 0.25%. These policies may change when inflation starts to become more noticeable in the grocery stores.

I think we may have recently made the switch from bonds being a flight to safety to cash being a flight to safety. Once that stage ends, I think the flight to safety will be precious metals and commodities.

Gold and commodities in general have gone through a two year corrective period. They are priced fairly low right now. Stocks and bonds are near all time highs. But the tide seems to be changing. And one thing that isn't mentioned by the author is that the U.S. has never been in a market environment like this. Never has credit been expanded like this before. When was the last time the funds rate was held at 0 - 0.25% for over four and a half years and counting? Well, that's because our financial system has never been completely broken before like it is today. When was the last time we engaged in QE like we are today. Well, that's because of the same reason. Credit expansion is the only thing holding the normal everyday operations of the banking sector together. In the end, where do you want to have your wealth stored if the only policy option is to create more currency units?

Equities and inflation protected bonds would be better than being in cash, but from my persepective equities will go up much more slowly than precious metals because they already appear to be in a bubble. And there's always the possibility that the government would renege its promise to pay the interest on those bonds.

LOL! See page 18 of Warren Buffet's letter to shareholders from 2011: http://www.berkshirehathaway.com/letters/2011ltr.pdf Everything you wanted to know about gold in small number of concise paragraphs. If that doesn't persuade one, the classic B Traven book (and resultant movie), "Treasure of the Sierra Madre" just might.

"...the most likely result will be capital flight. In this process, China will be forced to reduce its savings and investments as it rebalances. But in this case, since China will no longer be able to invest as many funds abroad, real rates rise and the gold price should actually fall."

This statement makes little sense.

Capital flight reflects investors' desire to rebalance portfolios away from the RMB. Gold, obviously, is one of the possible target assets. By "China", in the statement, I presume you mean "PBOC". You're describing a process by which the PBOC sells dollars to private investors in exchange for RMB. The creation of RMB, all else equal, leads to a devaluation. A devaluation leads to inflation. Inflation leads to lower, not higher real rates.

It's like you're saying: "a Brazil crisis would result in capital flight leading to less Brazilian demand for US$ bank deposits and higher Brazilian real rates." During capital flight in Brazil, the opposite was true.

I think you make a good point, but I approached it from a different angle. China in particular has a very high national savings rate, and the PBoC invests much of these savings abroad in Treasuries.

I guess the argument would be that if China or India undergo a severe crisis, their savings rates would have to fall. This should push up the global real interest rate. It's not just people flying away from China to invest in the U.S. (which would raise U.S. real rates), but rather a change in the total level of savings.

I'm not sure about your treatment of "savings". Under capital flight, USD are transferred from the PBOC to private accounts at foreign banks. This is not a "fall in savings" unless the private sector spends those USD on imports.

That shift in ownership of USD might influence asset prices depending on the resulting change in the composition of the aggregate USD portfolio held by Chinese. If the PBOC prefers T-bonds and the private sector would rather have less duration risk, then the term premium may rise. Further, if the Chinese private sector prefers short duration USD assets, they may purchase gold, Tbills, or TIPS. I think there is a case to be made for the PBOC being a "non-market" buyer of duration. In other words, they are willing to absorb losses on their T-bond holdings as there is little political consequence. Private Chinese investors may be more sensitive to duration risk and therefore shift the USD portfolio away from Tbonds during capital flight. This may, or may not, produce a higher gold price.

A bit unrelated, but I wonder what your thoughts are on central bank holdings of gold (I honestly don't have any idea myself). Some questions:

1) Why do central banks still hold so much gold?

2) What's up with Washington Agreement on Gold (renewed in 2009 by 19 central banks) to limit gold sales? Why do central bankers still consider gold to be "an important element of global monetary reserves" if we're off the gold standard?

Full text:

"1. Gold remains an important element of global monetary reserves.

2. The gold sales already decided and to be decided by the undersigned institutions will be achieved through a concerted programme of sales over a period of five years, starting on 27 September 2009, immediately after the end of the previous agreement. Annual sales will not exceed 400 tonnes and total sales over this period will not exceed 2,000 tonnes.

3. The signatories recognize the intention of the IMF to sell 403 tonnes of gold and noted that such sales can be accommodated within the above ceilings.

4. This agreement will be reviewed after five years."

http://en.wikipedia.org/wiki/Washington_Agreement_on_Gold

3) I get that central bankers don't want to flood the market with gold all together, b/c they would suffer large paper losses on their balance sheets. Glasner wrote:

"If they try to unload their holdings they risk creating a self-fulfilling expectation that the price of gold is going to drop which would wipe out a huge portion of their assets. So central banks are now complicit in propping up the value of this essentially useless commodity."

But what are the negative consequences to central banks from paper losses on gold holdings? Why does it matter in a fiat system?

Remember that gold reserves can work in a similar way as foreign exchange reserves. Since gold is an international commodity, it can be exchanged for hard currency even if the country is undergoing an external crisis. Moreover, although I'm fairly bearish on gold in the blog post, the fact that gold yields aren't determined by inflation could be an advantage when it comes to holding it reserves. It means that even if the Fed decides to inflate away, even though the dollar may depreciate, the gold in reserve doesn't.

Now, why this necessitates a global agreement is beyond me. Perhaps central banks are trying to limit their Mark to Market losses? But in a time of currency crises, these agreements would do relatively little.

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If the reason for the crisis is capital flight and the Chinese undo the capital flight by selling off US assets then the two effects should cancel each other out I guess because the money "fleeing" has to go somewhere as well!?

I don't think it's appropriate to exclude 1974 and 1979-80 from the analysis. The events that occurred in those periods (US withdrawal from gold standard and soaring inflation) are precisely the types of events that justify gold investment. The end of the $35/ounce gold standard was an inevitable result of US monetary and trade policies, and most would argue that the runaway inflation of the late 70s was also caused by excessive monetary creation in an attempt to reduce supply-side "shocks" like OPEC price hikes. These discontinuities are not common but they do occur either as Black Swan events or as the inevitable result of unsustainable policies. Looking at the next 20 years I would worry about our unsustainable trade deficits, the fiscal problem of the US government, a shift by the BRICs from the Dollar Standard, revival of the Cold War, Global Warming, US political strife, as well as Black Swan events such as the Yellowstone supervolcano. From your statistical analysis I conclude that, IF you ignore discontinuous events, then the price of gold is largely determined by real interest rates. That seems reasonable statistically but it excludes a principal argument for holding some gold in the portfolio.

The point of the inconvenient data points is to show that inflation doesn't seem to be a consistent relationship, and that the real interest rate relation IS consistent. If you run the regression with both variables, it becomes apparent that the real rate has much more explanatory power than inflation.

Again, if you forecast supply shocks, then invest in gold. Earthquake risks, not Fed policy.

"So why do people associate inflation with high gold returns, when in actuality gold returns are driven by real rates?"

Because there are a bunch of crazy Keynesians out there demanding that inflation be deliberately used as a tool to force real rates into negative territory. Gold guarantees you won't get a real return of less than 0% long term (unless someone finds a cheap way to manufacture synthetic gold, which seems unlikely).

"In fact, given gold's relationship with real rates, it can be best described as a leveraged bet that real rates will fall."

Demand for gold is quite capable of collapsing. For centuries, really, the price has been well above the fundamentals-driven value (which would be determined by jewelry and electronics). This means gold is an unreliable hedge and may well do worse than 0%.

" the positive relationship between gold and inflation is almost entirely driven by three data points: 1974, 1979, and 1980. Once you drop those three years worth of observations.." - once you remove these 3 years, why don't you remove 3 more? Why don't you remove ALL BUT 3 years, I'm sure you can make your case much stronger if you get rid of the "inconvenient" data points. I for instance would like to remove 1929, 1987 and 2008 from the Dow Jones chart and demonstrate that stock markets never experience crashes.

Now, back to gold: nobody, and I mean NOBODY who's been in the gold market is buying it because they fear that "inflation" will go up to 3 or 3.5%, as the economists believe is the "worst case scenario." No, gold is bought by 1) the speculators/flippers, b) by people hedging against one or a combination of: a systemic collapse, a devaluation a-la FDR, dumping of $2 trillion in US Treasuries and repudiation of the dollar by foreigners. They're not prepping for a 3% CPI increase, they're prepping for $400 oil and $10/gallon of unleaded...

Second, regarding the "crisis in China and India" theory... Well, while yours is a nice theory, in the real world we've seen over last several weeks that Indians with means are scrambling to buy as much gold and dump as much of their currency as they can, despite 10% tax and import ban. The Chinese are in an eve worse shape: if real estate prices fall, they'll have nothing to invest into PERIOD.

If/When India and China experience the crises and their currencies depreciate, there will be a flood of new money going into REAL gold, and no amount of mythical gold futures will be able to satisfy that demand. Of course, one can hope that the chinese will turn to US Dollars, but somehow i doubt that given a choice of importing more USD and US Treasuries vs importing more gold, the Chinese authorities will prefer more of oh-so-easy-to-print USD and UST than the real precious metal, regardless of its spot price in the paper currencies.

"It’s my hypothesis that Summers and Barsky are on to something and that we can use their insight to build a model for the price of gold. The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates."

and concludes that, "gold acts like a highly-leveraged short position in U.S. Treasury bills." Similar idea to what is written here, except he is using t-bills instead of 10 year treasuries.

Gold is suitable for the poor in countries with chronically weak currencies as a reserve against penury.It is also suitable for anyone as a hedge against hyperinflation in countries at risk of revolutions that would debase the currency eg the Arab Spring.

If you guys want to see what gold correlates to, run a chart graphing oil & gold dating back to 1971, when the US left the gold standard.

The correlation is very, very good.

The next question is "Why would the most valuable commodity known to man correlate so well to what is referred to by most as the most useless commodity known to man?"

Unless somebody very important never left the gold standard in 1971...say some country that was the key player in the Petrodollar arrangement...a country that has had a longstanding affinity for gold...and might be unwilling to sell its depleting valuable oil for paper IOUs of a debtor nation?

Gold is a precious metal whose value is determined by market inflation, market crisis and influenced by consume and disposal of gold by customers. Gold is considered as sure money. Comparing with other commodities it doesn’t perish. Although the gold price today have diminished over the past couple of years but gold always play a crucial role at the time currency devaluation.